Your Core Portfolio: Special Situations

Turnarounds, speculative plays, shorts — this is where the biggest profits often lie

Most wealth managers and mutual funds stick to a very disciplined and specific approach, hoping they will beat the market. The problem is that it doesn’t allow for a manager’s expertise in certain areas to make a difference.

But you don’t have any such problem, and neither do I.

The “Special Situations” part of our Core Portfolio allows the investor to address a given company that he has specific knowledge about in some way. Perhaps the investor is a debt collector, so he knows about debt stocks. Or maybe he is a member of the trade association of auto parts suppliers. Or maybe he has just followed a company for years and years and sees something few others might not.

These situations usually involve some form of speculation — the stock might either go bankrupt or to the moon. It might involve a turnaround. It might be a screaming short.

Best Buy (BBY) is one such example. The company is in the midst of a turnaround. Some people think it’ll work. I happen to think it will fail. For instance, why would I care about Best Buy’s online sales strategy? Amazon (AMZN) can afford to beat it every time, which is why Best Buy’s promise to match online pricing in its stores is crazy — it destroys margins by offering online pricing while paying the same expenses it always did as a brick and mortar operation. Free cash flow has gone negative. However, it isn’t quite time to short, so it’s on my core portfolio’s special situations watchlist. When it’s ready, watch out.

JCPenney (JCP) would appear to be a special situation, but I’m actually staying away from betting either way. Now that Pershing Square Capital Management has left the building, and left Penney in worse shape, it’s possible things will improve at the retailer, or it might be a slow march to death. I can’t tell either way — however, if you’re more in the know about retail than I am, this would make a prime candidate for the special situation slot of your core portfolio.

Netflix (NFLX) is a perfect example. Some people think it belongs in the large-cap growth category of our core portfolio, but I disagree. I think the company is built on smoke and mirrors. With more than $6 billion in off-balance sheet obligations — of which $2 billion is due in less than a year — and with only $1 billion in cash and short-term equivalents, I don’t see how Netflix meets those payments. That hasn’t stopped the market from pushing the stock over $300. Netflix is a short, but not yet. When it becomes one, it’s right for this asset class.

While searching for some preferred stocks to buy today, I came across several companies that offer preferred stocks but whose underlying common stocks seemed to be in trouble. Magnum Hunter Resources (MHR) is an integrated, independent oil and gas company that has lost money every year since 2010 and is losing money again this year. It has massive negative free cash flow (almost $500 million of it in 2012), and only has $86 million in cash offsetting $665 million in debt. The interest expense on that debt only adds to its operating losses. The company pays preferred dividends on top of all this. It’s all unsustainable. This is exactly the kind of short sale play that would be acceptable in the “special situations” section of our core portfolio.